MERCHANDISING OPERATIONS AND THE MULTI-STEP

INCOME STATEMENT
LO 1: Describe merchandising operations and inventory systems.
• Primary source of revenue for merchandisers like Walmart that buy and sell goods is referred to as
sales revenue.
• Cost of goods sold is the total cost of merchandise sold during the period.
o It is an EXPENSE that is directly related to the revenue recognized from the sale of goods.

Ex: Company C, a retailer, bought chairs from a wholesaler for $15 each. Company C then sold the
chairs to their customers for $20 each.

• The $20 represents Company C’s sales revenue for each chair.
• The $15 that Company C spent on each chair represents Company C’s cost of goods sold and
is recognized when each chair is sold to customers.

***Key Formula: Sales Revenue – Cost of Goods Sold = Gross Profit

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 FLOW OF COSTS
• Companies use either a perpetual inventory system or a periodic inventory system to account for
inventory.

1. Perpetual: CONTINUOUSLY updates accounting records for merchandising transactions –

SPECIFICALLY reduction of inventory and increasing cost of goods sold.

• Advantages of perpetual inventory system.

1. Traditionally used for merchandise with high unit values.
2. Shows the quantity and cost of the inventory that should be on hand at any time.
3. Provides better control over inventories than a periodic system.

2. Periodic: updates the accounting records for merchandise transactions at the END OF A PERIOD.

• Cost of goods sold determined by count at the end of the accounting period.

***Key Formula… Cost of Goods Sold = Beginning Inventory + Net Purchases – Ending Inventory

Beginning Inventory $ 200,000

Add: Purchases, net $ 900,000
Goods available for sale $ 1,100,000
Less: Ending Inventory $ 400,000
Cost of Goods Sold $ 700,000

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 LO 2: Record purchases under a perpetual inventory system.
FREIGHT COSTS

Shipping Terms Ownership Transfers when goods passed to Freight cost paid by

1. FOB (Free on Board) 1. BUYER

Shipping Point: GOODS 1. CARRIER
Inventory xxx
ARE BUYERS AS SOON AS
Cash xxx
CARRIER GETS THEM.

2. FOB (Free on Board) 2. SELLER

Destination: GOODS ARE 2. BUYER
SELLERS UNTIL THEY REACH Freight-Out xxx
BUYER. Cash xxx

Del

PURCHASE DISCOUNTS
• Buyer receives a cash discount for prompt payment.
• Saves the buyer money and helps the seller collect money faster.

What does this mean?

*The buyer can deduct 2% of the invoice amount if
payment is made within 10 days of the invoice
date, otherwise full payment is due within a
30-day credit period.
*Simply…The buyer gets a 2% discount if they pay
within 10 days, otherwise the full amount is due in
30 days.

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 PURCHASE DISCOUNTS (Cont.)

1% discount if paid within first 10 days of next month.

Net amount due within the first 10 days of the next month.

PURCHASE RETURNS AND ALLOWANCES

• Purchase Returns: Return goods for credit if the sale was made on credit, or for a cash refund if the
purchase was for cash.
• Purchase Allowances: May choose to keep the merchandise if the seller will grant a reduction of
the purchase price.

Summary of Purchasing Journal Entries- Perpetual

DEBIT CREDIT
Inventory xxx
1. Purchase inventory ON ACCOUNT.
Accounts Payable xxx

Inventory xxx
2. Purchase inventory for CASH.
B Cash xxx

U 3. Paying freight costs on purchases (FOB Shipping Point)

Inventory
Cash
xxx
xxx

Y Accounts Payable xxx

4. Paying WITHIN discount period. Inventory (For purchase discount) xxx
E Cash xxx

R 5. Paying OUTSIDE discount period.

Accounts Payable
Cash
xxx
xxx

Cash or Accounts Payable xxx

6. Recording Purchase Returns and Allowances. Inventory xxx

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 Example Journal Entries
Jay Company bought inventory from Z Company on January 1 for $10,000 under the credit terms 3/15,
n/60. On January 10, Jay Company returned goods costing $1,000 to Z Company. Jay Company paid Z
Company for the remaining goods on Jan. 12.

What are the journal entries that need to be recorded in January for Jay Company?

Date Debit Credit

Inventory Jan. 1 10,000
Accounts Payable- Z Company 10,000

Accounts Payable- Z Company Jan. 10 1,000

Inventory 1,000

Accounts Payable- Z Company (10,000 – 1,000) Jan. 12 9,000

Inventory (9,000 × 3% = $270) 270
Cash 8,730

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LO 3: Record sales under a perpetual inventory system.

SALES RETURNS AND ALLOWANCES

• Used when the seller either accepts goods back from a purchaser (a return) or grants a reduction in
the purchase price (an allowance) so that the buyer will keep the goods.
• Contra-revenue account on the income statement and has a Debit balance.

SALES DISCOUNTS
• Issued by the seller to obtain their money from the customer faster.
• Contra-revenue account on the income statement and has a Debit balance.

Sales Revenue – Sales Returns and Allowances – Sales Discounts = Net Sales

Net Sales – Cost of Goods Sold = Gross Profit

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 Example Journal Entries
• Jay Company sold goods costing $6,000 to X Company for $10,000 on March 1 under the terms
2/10, net 30. On March 5, X Company returned goods to Jay Company with a selling price of $3,000
and a cost of $1,800. On March 10, Jay Company received payment from X Company for the
remainder of the goods.

What are the journal entries that need to be recorded on in March for Jay Company?

Date Debit Credit

Accounts Receivable- X Company Mar. 1 10,000
Sales Revenue 10,000

Cost of Goods Sold Mar. 1 6,000

Inventory 6,000

Sales Returns and Allowances Mar. 5 3,000

Accounts Receivable- X Company 3,000

Inventory Mar. 5 1,800

Cost of Goods Sold 1,800

Cash Mar. 10 6,860

Sales Discounts (7,000 × 2% = $140) 140
Accounts Receivable- X Company (10,000 -3,000) 7,000

LO 5: Apply the steps in the accounting cycle to a merchandising company.

Each of the required steps described in Chapter 4 for service companies applies to
merchandising companies.
Adjusting Entries
A merchandising company generally has the same types of adjusting entries as a service
company. However, a merchandiser using a perpetual system will require one additional
adjustment to make the records agree with the actual inventory on hand. Here’s why: At the end
of each period, for control purposes, a merchandising company that uses a perpetual system will
take a physical count of its goods on hand.
The company’s unadjusted balance in Inventory usually does not agree with the actual amount of
inventory on hand. The perpetual inventory records may be incorrect due to recording errors,
theft, or waste. Thus, the company needs to adjust the perpetual records to make the recorded
inventory amount agree with the inventory on hand.

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 • This adjustment impacts Inventory and Cost of Goods Sold.
For example, suppose that PW Audio Supply, Inc. has an unadjusted balance of $40,500 in
Inventory.
Through a physical count, PW Audio Supply determines that its actual merchandise inventory at
December 31 is $40,000. The company would make an adjusting entry as follows.

Dec. 31 Cost of Goods Sold 500

Inventory ($40,500 – $40,000) 500
(To adjust inventory to physical count)

Closing Entries
A merchandising company, like a service company, closes to Income Summary all accounts that
affect net income. In journalizing, the company credits all temporary accounts with debit
balances, and debits all temporary accounts with credit balances. It also closes both Income
Summary and Dividends to Retained Earnings. (Hint – R.E.D – temporary accounts are
Revenue, Expense, and Dividends)

The following are the closing entries for PW Audio Supply using assumed amounts from its
year-end adjusted trial balance.
• Cost of Goods Sold is an expense account with a normal debit balance,
• Sales Returns and Allowances and Sales Discounts are contra revenue accounts with
normal debit balances

The easiest way to prepare the first two closing entries is to identify the temporary
accounts by their balances and then prepare one entry for the credits and one for the
debits.
Dec.31 Sales Revenue 480,000
Income Summary 480,000
(To close income statement accounts with credit
balances)
31 Income Summary 450,000
Sales Returns and Allowances 12,000
Sales Discounts 8,000
Cost of Goods Sold 316,000
Salaries and Wages Expense 64,000
Freight-Out 7,000
Advertising Expense 16,000

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 Utilities Expense 17,000
Depreciation Expense 8,000
Insurance Expense 2,000
(To close income statement accounts with debit
balances)
31 Income Summary 30,000
Retained Earnings 30,000
(To close net income to retained earnings)
31 Retained Earnings 15,000
Dividends 15,000
(To close dividends to retained earnings)
After PW Audio Supply has posted the closing entries, all temporary accounts have zero
balances. Also, Retained Earnings has a balance that is carried over to the next period

LO 5: Prepare a multi-step income statement

SINGLE-STEP INCOME STATEMENT
• Subtract total expenses from total revenues
• Two reasons for using the single-step format:
1. Company does not realize any type of profit or income until total revenues exceed total
expenses.
2. Form is simple and easy to read.

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 MULTI-STEP INCOME STATEMENT
• Highlights the components of net income.
• Three important line items:
1. Gross profit
2. Income from Operations
3. Net Income

•
***ALL OF THESE ITEMS ARE PART OF NONOPERATING
ACTIVITIES AND ARE ADDED OR DEDUCTED FROM INCOME
FROM OPERATIONS TO GET INCOME BEFORE TAXES.

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